Take a moment to think back to the days you were sitting in your first Economics class in high school. It probably started with a definition of Economics and an explanation of concepts such as scarcity, resources, opportunity cost, among others.
Three or four classes in and you probably began to learn about taxation. Some of the topics would include Adam Smith’s canons of taxation, taxation as fiscal policy, among others. Today, I want you to think back to the time you learnt about the different types of taxes – proportional, progressive, and regressive.
Perhaps you learnt them back then to pass your exams, and you have no clue how they affect your finances today.
Well, this is an opportunity to revisit that class. We will look at the three different types of taxes, how they affect your finance, and some examples of how they work in real life.
Let’s dive in.
What are Proportional Taxes?
Proportional taxation is a tax system that levies the same tax rate on individuals irrespective of their income or wealth.
Another name for proportional taxation is flat tax.
The rate of taxation does not change with increasing or decreasing levels of income or wealth.
Some states in the United States levy income tax based on the proportional tax system. These states include Colorado, Illinois, Indiana, Kentucky, Massachusetts, North Carolina, Pennsylvania, and Utah.
For example, if you live in Colorado, your state income tax rate is 4.63% irrespective of income. The tax rate is 4.95% in Illinois and 3.23% in Indiana.
How do proportional taxes work?
Let’s say Mr Johnson is a financial analyst who earns an income of $80,000 in Colorado while Mrs Jane is a nurse who makes $60,000 in the same state.
Mr. Johnson’s tax liability is $3,704 (4.63% * $80,000) while Mrs. Jane’s tax liability is $2,778 (4.63% * $60,000).
The income tax rate does not vary with income level.
Other types of taxes that use the proportional tax system include:
- Occupational Taxes
The financial dictionary defines occupational taxes as “Taxes and fees levied on particular jobs and businesses. A liquor license for a bar and a health permit for a restaurant are both examples of occupational taxes. In the United States, occupational taxes are assessed at the state and local levels and generally are flat fees.”
- Per Capita Taxes:
They are taxes levied on the residents of a jurisdiction above a certain age. Per capita taxes are also known as head taxes.
They depends on residency rather than income or wealth. Per capital taxes are proportional taxes.
What are the advantages of Proportional Taxes?
Proponents of the proportional tax system believe it encourages hard work since your tax rate will not change even with a higher level of income.
They also believe it is fair. One advocate of proportional taxes is Ben Carson. He wrote, “I’ve advocated a proportional tax system. You make $10 billion, you pay a billion. You make $10, you pay one. And everybody gets treated the same way.”
Also, the proportional tax system removes the complications from tax computations. Every Tom, Dick, and Harry can compute the taxes due on their income.
Gary Cohn believes this is an essential goal for any tax system. In his words, “We want to go back to a tax system where Americans sit down at their kitchen table, and they do their taxes on a single sheet of paper. That’s what we should have in this America.”
However, critics of the proportional tax system (those on the progressive side) will argue that it does not satisfy the canon of justice and equality since it treats low-income earners in the same way as high-income earners.
Other critics (those on the regressive side) will argue that it does not incentivize hard work and higher income since there is no tax advantage from an increase in income level.
What are Progressive Taxes?
Progressive taxation is a tax system where the tax rate is directly proportional to the income level. The higher the income, the higher the effective rate of tax, vice versa.
The United States Federal Income Tax follows the progressive tax system.
The Federal Income Tax uses a tax table that begins with a 10% tax rate on income less than or equal to $9875 for single filers, $19,750 for joint filers, and $14,100 for a head of household.
The table ends with the 37% marginal tax rate for incomes exceeding $518,401 for single filers and head of household, $622,051 for joint filers, $311,026 for married couples filing separately.
How do progressive taxes work?
Say Mr Price earns $40,000 as a CPA and Miss Judith earns $90,000 as an investment banker. Let’s also assume that they are both single filers.
Mr Price’s tax liability from the tax table will be as follows:
First $9,875 –> 10% * $9875 = $987.5
Next $30,125 ($40,000-$9,875) -> 12% * $30,125 = $3,615
Total Tax Liability = $4,602.5
Effective Tax Rate = $4,602.5/$40,000 = 11.5%
Miss Judith’s tax liability from the tax table will be as follows:
First $9,875 –> 10% * $9875 = $987.5
Next $30,250 ($40,125-$9875) -> 12% * $30,250 = $3,630
Next $45,400 ($85,525-$40,125) -> 22% * $45,400 = $9,988
Next $4,475 ($90,000-$85,525) -> 24% * $4,475 = $1,074
Total Tax Liability = $15,679.5
Effective Tax Rate = $15,679.5/$90,000 = 17.4%
Miss Judith, who earns more than Mr Price does, is subject a higher tax rate (17.4%).
The estate tax is another progressive tax. They are payable on estates with assets exceeding $11.4 million at the federal level. At the state level, the limit is lower, which draws more estates into the tax pool. The tax rate on estates increases with their value.
What are the Advantages of Progressive Tax?
Advocates of progressive tax believe it promotes equality and justice since higher-income earners have a higher capacity to pay.
Critics of the progressive tax argue that it is an income redistribution strategy that takes from the rich to sponsor programs designed for the poor (remember Robinhood?).
They argue that such programs discourage people from working hard and increasing their income since such an increase in income leads to higher tax rates.
If the calculation above seems like rocket science to you, then you are not alone. Critics of progressive tax system believe it is too complicated and stressful. Even Alfred Neuman commented that “Today, it takes more brains and effort to make out the income-tax form than it does to make the income.”
What are Regressive Taxes?
The regressive taxation system is the opposite of the progressive system. The effective tax rate in this system increases as income level falls (inversely proportional). People with higher income levels pay taxes at a lower tax rate while those with lesser income pay taxes at a higher income rate.
The regressive tax structure occurs where tax is a fixed amount relative to income because the taxing authority calculates the tax rate on a basis (consumption, asset) other than income levels.
That is, though the tax rate is constant, it is not calculated on income levels like the proportional tax system.
In the case where it is calculated on income levels (social security tax), there is a cap on the amount of income subject to tax which makes people with higher income level enjoy a lower effective tax rate compared to people with lower income level.
The sales tax on goods is an example of a regressive tax system.
How do Regressive Taxes Work?
Let us say Mr Bauer and Mrs Chloe purchase items worth $3,000 in the grocery store on the same day. With a sales tax of 6%, they will have a tax liability of $180 each.
However, if Mr Bauer’s income is $100,000 and Mrs Chloe’s income is $50,000, the former has just paid 0.18% of his income as sales tax while the latter paid 0.36%.
If at the end of the year, they both spent $20,000 in the grocery store; their sales tax liability will be $1,200. For Mr Bauer, this is 1.2% of his income. For Mrs Chloe, this is 2.4% of her income. Mr Bauer has a lower effective tax rate even though his income is higher.
Other types of regressive taxes include:
- Property taxes:
Property taxes are calculated on the value of a property. If two people with different income levels pay the same property tax, the proportion of tax to income will be lower for the person with the higher income and higher for the person with the lower income.
- Specific excise taxes:
They are fixed dollar amounts added to a product on a per-unit basis.
Since the tax liability is the same irrespective of income, higher-income earners have a lower effective tax rate compared to lower-income earners.
- Social Security Taxes:
Social Security is a 6.2% tax on income. However, the tax is not payable on income exceeding $137,700.
Therefore, for someone earning $200,000, he will only pay $8537.40 in social security tax. Someone earning $1,000,000 will only pay $8537.40.
Consider two individuals: Mr Scofield, who earns $100,000 and Mr Burrows, who earns $200,000. Mr Scofield will pay $6,200 in social security tax while Mr Burrows will pay $8537.40. The effective tax rate of the former is 6.2% ($6,200/$100,000) while the effective tax rate of the latter is 4.3%.
The example above shows that the one with the higher income has a lower effective tax rate, and the one with the lower income has a higher effective tax rate.
What are the Advantages of Regressive Tax?
Advocates of the regressive tax system believe it incentivizes hard work by rewarding high-income earners with the lower effective tax rate.
Critics argue that the regressive system does not align with the canon of equity and justice.
The three types of tax have advantages and disadvantages. Different economies use a mix of the three systems in different ways. Proportional and progressive taxes are common with taxes on income, while regressive taxes are common with taxes on consumption.
Understanding the three different tax systems will help you get a handle on your tax situation and explore ways to increase your tax efficiency.
Do you want to learn more about how taxes affect your financial situation? Subscribe to the mailing list to be notified when the next article is live.
If you are new, check the first article in this series here.
Check out last quarter’s series on retirement planning here.